There are two established explanations for bank runs: coordination problems among depositors and information asymmetries between bank managers and depositors.  In a new paper, “Information Gaps and Shadow Banking,” forthcoming in the Virginia Law Review and available here, I offer a novel, complementary explanation for why short-term creditors run: information nobody possesses.

Both the banking and shadow banking systems use short-term debt to fund longer-term, less liquid assets.  That short-term debt is designed to pose sufficiently minimal credit, liquidity, and duration risk that holders can treat the claims as close substitutes for money.  This reduces funding costs and has other advantages for the institutions that issue such debt, but it also renders those institutions inherently fragile. Holders of short-term debt can exit quickly.  When they do so en masse—a run—an institution will often be forced to sell assets at discounted, fire sale prices.

Adverse macroeconomic developments or other signals that cast doubt on whether outstanding short-term debt is still safe enough for holders to treat it like money is a common trigger for runs.  In the case of banks, the short-term creditors are depositors.  Whether bad news will prompt a run depends on the ability of a bank’s managers or its regulator to assure depositors that their claims remain sufficiently safe that there is no reason to exit.  A bank, for example, may provide credible information about the value of the loans that it holds, or a regulator may verify the bank’s health.

In contrast, the short-term debt issued in the shadow banking system takes forms like asset-backed commercial paper (ABCP).  The value of ABCP depends not only on the value of the underlying loans, but also on the terms of the ABCP, the terms of the securitization structures that transformed the underlying loans into the the asset-backed securities packaged into that ABCP conduit, and other factors.  Moreover, in contrast to the banking system, there is no prudential oversight of the institutions issuing the short-term debt.  As a result, there is often no party, private or public, with the information required to assess the implications of bad news on the creditworthiness of outstanding ABCP.  In the face of bad news, money claimants still have the capacity and incentive to run. But, in contrast to banks, no one has the information that might stop them.  Information gaps thus operate alongside information asymmetries and coordination challenges to exacerbate the fragility of the shadow banking system.

Information gaps also impede the private and public mechanisms that can dampen the impact of a shock and help restore stability once panic takes hold.  Runs often indicate that an institution issuing money claims needs more loss-absorbing capital.  Private investors will not provide that capital, however, unless they can price it.  The cost of gathering and analyzing the pertinent information creates a friction deterring the entry of private capital. The government also has an array of tools, such as guarantees, capital support, and liquidity support, to prevent and contain runs.  These too, however, can only be deployed effectively when the government has high-quality information about the size and location of the downside risks causing money claimants to run.  Lacking such information, the government response may be too late or too modest, exacerbating the size of a crisis, or too expansive or too generous, increasing the credit risk to which the government is exposed and the moral hazard the response engenders.  My paper shows that both empirical and anecdotal evidence from the 2007-2009 financial crisis is consistent with the paper’s claims regarding the ways information gaps exacerbate fragility and inhibit effective response.

The novel explanation for runs by money claimants is the paper’s main theoretical contribution.  In laying the foundation for that claim, however, the paper also provides new insight into why the current regulatory regime is so ill-suited to address the unique challenges posed by shadow banking.  Shadow banking, or market-based intermediation, entails the extension of credit and the creation of money claims in the capital markets. Unlike the banking system, where information-insensitive deposits are the primary way of bringing capital into the system, information sensitive claims, like common stock, are the paradigmatic instrument issued in the capital markets. The difference in the instruments issued in the two systems resulted in two very different regulatory regimes.

My article explains how securities and bank regulation have evolved to address the informational needs of the equity and money claimants, respectively. Equity claimants are strongly incentivized to gather and analyze information.  Securities regulation harnesses and facilitates these inclinations through a regime that relies on market participants to assess the value of assets underlying an equity claim. The primary role of regulation is to facilitate these market-based processes.  Money claimants, by contrast, tend to be skittish and minimally informed.  The banking system addresses these dynamics through the creation of a powerful body of regulators authorized to limit bank activities, supervise bank operations, provide liquidity to a healthy bank facing excessive withdrawals, and close a bank if its financial health becomes too precarious.  In each case, someone has high-quality information about the undertakings being funded by the capital coming into the system, the nature of the associated risks, and the ability to take actions responsive to those risks.

The same is not true with respect to shadow banking. The shadow banking system is an interconnected web of institutions that operates largely in the capital markets. This means that the default regulatory regime governing the shadow banking system is the disclosure-oriented regime designed to govern equity claims and other investments.  But money claimants do not have the same incentives as equity investors—they will walk away before engaging in meaningful information collection and analysis.  This has little to do with the claimants, who are often the same sophisticated parties that undertake the information-generating activities that promote efficiency in the equity markets. Rather, it is inherent in the nature of money. A financial claim ceases to function as money if the holder perceives there to be any meaningful credit risk, or even if the holder is uncertain about the amount of credit risk a claim poses. As a result, it will often be the case that no one has high-quality information about the assets underlying the shadow banking system, how risks are allocated across that system, and other pertinent information.

This post comes to us from Professor Kathryn Judge of Columbia Law School. It is based on her recent article, “Information Gaps and Shadow Banking,” available here.